Monday, July 18, 2016

The Yipee Stock Market?

It’s been three weeks since British voters shocked the world and voted to leave the EU. After a two-day Brexit freakout, the stock market pretty much returned to business as usual—and beyond. The S&P 500 hit record highs four straight days this week, its longest streak since November 2014, before retreating slightly on Friday.

Even the gruesome news from Nice, France—where 84 people were killed and more than 200 injured when a truck rammed into a crowded festival—seemed to have little impact on the financial markets Friday. Indeed, Herbalife’s (HLF) settlement with the FTC and Wells Fargo’s (WFC) lackluster results were more top of mind for U.S. traders. (Update: Reports of a coup attempt in Turkey broke shortly after the market closed on Friday; S&P 500 e-mini futures slipped initially after-hours trading in reaction before recouping most of the lost ground.)

Here are three reasons why the market has surged, even though the world seems to be coming apart at the seams:

Money Is Cheap: Not everything comes down to the Fed, but easy money promotes speculation. If traders can borrow for (almost) nothing, they’re more willing take a flyer on some high-beta stocks like Ocean Power Technologies (OPTT) that might provide a huge payoff. Add that easy money to quantitative easing programs by global central banks and you get a steep drop in bond yields. That, in turn, makes stocks look relatively attractive to institutional investors. Finally, access to cheap capital allows corporations to borrow money to buy back stock, which reduces the supply of stock available and improves earnings per share, albeit artificially. After companies bought back about $161.4 billion of stock in the first quarter, outstanding shares in the S&P 500 are on track for the first yearly decline since 2011, the WSJ reports, citing data from S&P Dow Jones Indices.

People are Emotional, Markets are Not: I don’t believe markets are particularly rational or efficient, but the impact of terrorism on financial markets has steadily waned in the years since the Sept. 11 attacks on New York City. It may be callous to say, but we’ve all become a bit numbed to terror attacks after London (2005)…Spain (2014)…Paris (2015)…Brussels (2016).

The World Isn’t Ending: While there’s plenty to worry about—including global terrorism, uncertainty over what Brexit really means, anxiety over how U.S. election plays out, and much more—the global economy is expanding, albeit slowly, and the U.S. looks pretty good relative to other developed economies. (Insert “best looking horse in the glue factory” joke here.) And despite legitimate concerns about anti-globalization forces being on the rise here and abroad, the volume of global trade is expected to rise 2.6% this year after climbing 2.8% in 2015.

An old Wall Street saying also helps explain why stocks have fared well despite all the negative headlines: The market climbs a wall of worry.

You should be more worried about the stock market when “everyone” is bullish and the conventional wisdom says buying stocks (or real estate or any other asset) is a “no brainer.” That is certainly not the case today: UBS says wealthy investors are holding on to record levels of cash and 84% believe the election will have a significant impact on their financial health, Reuters reports.

Other sentiment indicators tell a similar tale: The American Association of Individual Investors Sentiment Survey has been above 30% bullish in consecutive weeks only two times since November.

Other signs of worry include gold’s more than 25% increase in 2016, and investors’ willingness to buy bonds with negative rates. Germany sold 10-year bunds at negative rates for the first time ever this week and there is now about $13 trillion of global debt with negative yields, the WSJ reports, citing data from Bank of America Merrill Lynch. That’s up from $11 trillion before the Brexit vote.

Notably, the so-called fear indicator, the VIX, has fallen over 50% from its peak in late June and is trading at levels below 13, suggesting complacency among options traders. Furthermore, ETF funds tracking major U.S. stock indexes attracted $11.5 billion over the five days through Thursday, the most in 10 months, according to Bloomberg. The pre-teen VIX and heavy inflows into equity ETFs suggest that short-term optimism has risen almost as quickly as the S&P 500, which is up 8% since its post-Brexit-vote low. In other words, don’t be surprised if the market takes a short-term respite from its recent rally.

That said, it does seem like it’s going to take a lot more than a few scary headlines to knock the market down, at least for very long.

Below are two charts — one representing 2007 and one from this past year. In each chart, the Dow Jones Industrial Average is the solid black line, while the Dow Jones Transportation Average is the solid red line.

Let’s break down 2007, then I’ll focus on 2016 so you can see the resemblances.

You can see at the first circle that the transportation average is creating slightly lower lows, while the industrial average has higher lows. This point marks a divergence from the trend, but it’s still too early to call a crash.

At the second circle, we have higher highs for the industrial average, but lower highs for the transportation average. The two are still opposite of each other and not yet conforming to a crash reading.

At circle three, we see both averages fall to lower lows, signaling a partial confirmation. But at circle four we see a rally, sending the transportation average to all-time highs. The key thing here at point four is that the industrial average has finally confirmed the bear market by setting lower highs.

From June 5, 2007, to the end of the year, both averages lost roughly 30% of their value in less than six months.

Dow Theory held true. It just takes time for the trends to become clear — hindsight is always 20/20.

These divergences from the trend in 2007 marked the first such occurrences since the 2001 dot-com bubble, and we’re seeing them again in 2016.

In the first circle, we see that the Dow Jones Industrial Average is setting a lower low alongside the transportation average. At the second circle, we see lower highs for both.

At this point, I was convinced a bear market was in full effect. I recommended grabbing put options and launched Pure Income as a means to collect income in any market environment.

At circle three, the industrial average failed to make clear lower lows, sending it back to higher highs today … circle four. Remember, we are watching for divergences between the two averages as an early warning signal of a new bear market.

The fact that the transportation average failed to partake in the recent rally after both made lower highs and lower lows tells me the negative investment sentiment is still here, and this is likely the last push higher for the Dow.

That’s why I’m using this recent rally as an opportunity to prepare for the coming bear market.

Preparing for the Bear Market Crash

Like in 2007, the averages are already signaling a bear market, with the transportation average making lower lows and lower highs. The industrial average will likely play catch-up for the rest of this year.

Dow Theory itself says that either average can lead the other — they just both have to eventually conform to either a bull or bear market. Right now, we are in the transition stage from one to the next, and it’s not always a clean-cut transition, as we saw in 2007 when the transportation average made one last run to higher highs.

The only safe bets to place … are bearish ones.Until we see higher highs and higher lows from both averages, you have to position yourself to protect against a bear market. Keep in mind bear markets tend to not last too long. The one in 2008 crashed in September and October, bottoming just five months later.

So once you capture modest gains from a sharp bear-market move, take profits and wait for stocks to form a bottom. Then you can begin looking to pick up many of the stocks you took profits on at far cheaper prices.

Fully 100 companies have defaulted on debt, 50 percent more than for the same period in 2015 and the highest level since 2009, according to S&P Global Ratings.

Low oil and commodity prices, along with financial market volatility in the United States and abroad, have been the primary problems for the bond market this year. While the actual ratio of distressed issues is on the decline, the level of defaults has climbed.

While the defaults have been weighted heavily to the energy sector, analysts at S&P said there's no guarantee things will stay that way.

"Over the past year, we have seen a strong increase in both the number and percentage of defaults in the energy and natural resources sector," the agency said in a note. "So far, there has been little spillover effect into other sectors, but we are not ruling this out in the coming quarters."

The distressed level declined to 17.1 percent in June, the fourth consecutive monthly drop. Of the 300 issues categorized as distressed, 22 percent came from the energy sector.

Multiyear highs in defaults have failed to dampen investor appetite for corporate debt.

Trading volumes are up 33 percent for investment-grade bonds and 22 percent for high yield, according to Bank of America Merrill Lynch. Flows have been strong as well, with fixed-income funds pulling in $7.95 billion last week, the highest level since February 2015, BofAML also reported.

When stocks move up or down, the high-yield bond market tends to move in lockstep. That relationship has been even stronger than normal in recent months.

The 50-day rolling correlation between the SPDR Barclays High Yield ETF and the S&P 500 is nearing 90 percent, the highest level reached in the eight years that junk ETFs have been available. The last time that the correlation between stocks and high-yield ETFs was this high was in early 2012.

Investors often track high-yield bonds in an effort to gauge risk appetite and predict any potential turns in market sentiment.

So far this year, the S&P 500 has been driven by sectors that are traditionally considered safe investments like utilities, materials, telecom and consumer staples as investors seek out safety during periods of volatility. But as markets reach new highs, that sentiment seems to be changing.

Flow data from Markit shows that investors are more willing to make bets on sectors that have been lagging this year.Financials, for example, has been underperforming the broader market this year, but have led inflows so far this month at $450 million. The consumer goods and consumer services sectors followed financials with more than $200 million each in inflows during the same period. The materials sector ETFs continue to attract investment with $448 million in inflows this month.On the flip side, sectors that performed well during the first half of the year are now seeing money coming out of them.

Utilities and energy had done extremely well from the beginning of the year until the end of the second quarter, but as the second half begins, both sectors are seeing significant outflows. Month-to-date, the two sector ETFs have seen almost $400 million and $300 million in net outflows, respectively.

Some believe that the appetite for risk has increased as concern about Brexit has evaporated in recent weeks. High-beta stocks have outperformed the market average so far this month, and short interest has declined for those stocks, signaling a "true" rally, said research analyst Simon Colvin at Markit.

"The general mood in the market this month is risk-on, shown by investors rotating into riskier parts of the market," Colvin said. "Low-beta stocks may still continue to attract investors. The momentum right now, however, belongs to stocks beaten down this year."

This is positive but as Gerard MacDonell points out, too many analysts misinterpret this index and pretend that data surprises have predictable time series
properties, when in fact these “properties” are just an artifact of how
the index is constructed.

The most hated bull market in history is finally getting some approval and love from investors.

As the soaring S&P 500 index (SPY) and Dow Jones Industrial Average (DIA) set records for the first time in nearly 14 months this week, bears, who doubted this market for years decided it was time to join the rally.

The weekly flows reflect a “risk-on” attitude of investors over the past week as worries surrounding Britain’s decision to leave the European Union have dissipated. Investors poured money into U.S. equities as well as speculative-grade corporate bonds and emerging market equities, which are considered risky.

According to Bank of America Merrill Lynch, July 11, when the S&P 500 ended in record territory, investors poured $6.4 billion into U.S. stock exchange-traded funds, the biggest one-day inflow since December 2015. The BAML declared the July 11 “the day when bears capitulated into risk assets.”

July 11 was also the day that saw the largest one-day inflow into high-yield bond funds, which attracted $2.1 billion (click on image).

Over the past week, emerging-markets equity funds saw their biggest flows since March.

“Within fixed income flows shifted markedly towards riskier assets, including high yield, EM and leveraged loans, and away from high grade, government bonds and munis. Flows generally follow returns, and the weakening of inflows to the safer parts of the fixed-income market likely reflects the increase in interest rates earlier this week,” wrote Yuriy Shchuchinov, credit strategist at BAML.

The 10-year Treasury yield rose more than 20 basis points over the past week to 1.57%, which is still below its 1.75% before the Brexit vote, when the U.K. decided to exit the European Union, but well above the record low hit last week at 1.33%.

Weekly U.S. equity flows were the largest since Sept 2015 at $11 billion, which is a net result of $17 billion into ETFs and $6 billion outflows from mutual funds (click on image).

BAML’s “Bull & Bear” indicator is still in the bearish territory, having triggered their contrarian “buy” signal two weeks ago. The bank analysts expect “more tactical upside ahead.”Investors fled European equity funds, however, redeeming $5.8 billion, the largest amount on record.

“There is an old adage on Wall Street saying that buying begets buying. Money goes to where it’s best treated and since there is a lot of cash on the sidelines, we might see more inflows into U.S. equities,” said Quincy Krosby, market strategist at Prudential Financial.The record-high levels on the main indexes have raised questions about ever rising valuations at a time when earnings growth is still negative.

“The explanation for the rally since Brexit had been the TINA argument, that there is no alternative, given how ultralow bond yields are,” said Mark Kepner, managing director of sales and trading at Themis Trading.

“But over the past few weeks, bond yields also recovered rapidly to the point where the valuation gap between bonds and stocks begins to narrow,” Kepner said. “If [bond yields] continue to rise to the pre-Brexit levels, buying stocks at these valuations will not be as attractive,” he added.

The S&P 500 is down slightly on Friday, but still on track to record its third consecutive weekly gain.

“Much depends on how the rest of the earnings season unfolds,” Kepner said. “Since economic data have been generally positive, if we can get good earnings, it would be positive for the markets,” he said.

“PE ratios in isolation have not historically been good forecasters of future returns because PEs must be related to interest rates and inflation,” Bernstein said in a research note on Wednesday. And as everyone knows, interest rates are historically low and inflation is almost nonexistent.

This isn’t exactly an earth-shattering discovery. Other analysts will argue the same thing.

“There is little statistical evidence that the P/E ratio returns to an average value,” Wells Fargo’s John Silvia wrote in March. “The long cycles we see in the P/E ratio are driven by economic factors. During the 1970s, the upswing of inflation and interest rates, along with the uncertainty of oil shocks and recessions, surprised equity markets and led to a downshift in the P/E ratio. In contrast, the steady decline of both interest rates and inflation in the 1980s led to an increase in P/E ratios.”

Indeed, investment analysis is not simple, and it certainly is a mistake to consider P/E ratios in a vacuum. That’s not to say there isn’t another shortcut that helps investors interpret the signals sent by prices relative to earnings.

“There is an old investment rule-of-thumb called the Rule of 20 that uses combinations of headline inflation and the S&P 500 P/E to determine fair value,” Bernstein said. “Our valuation models are, of course, more elaborate than the simple Rule of 20, but based on a more rigorous analysis of inflation and P/E ratios, the current equity market appears, at worse, to be fairly valued. Investors forget that inflation was increasing leading up to the 2008 bear market. In fact, the CPI, which is a lagging indicator, peaked at 5.6% in July 2008. Today’s headline inflation is 1.0%.”

To reiterate, investing is complicated. But to be clear, while there are a lot of things to factor when discussing prices and valuations in the near-term, earnings and expectations for earnings growth will continue to be the most important drivers of stock prices.

“Yes, stock prices tend to follow earnings over longer periods of time, but for shorter horizons (one year), the picture is more complicated,” BMO’s Brian Belski said.

[...] if you ask me, the rally in gold (GLD), silver (SLV), oil (USO), metal and mining (XME), energy (XLE) and emerging markets (EEM) shares which registered 8.6% gain in the first-half this year, outperforming developed markets by 5.5%, the best first-half performance since 2009, is nothing more than a function of the weak US dollar (DXY). And because I see the US dollar gaining strength in the second half of the year, I would steer clear of all these sectors including gold and silver.

[...] I would be very careful here. There are multi billion dollar quantitative CTA funds playing trends in stocks, bonds, commodities and currencies and they too are distorting these markets on the downside and upside.

Where I disagree with Gundlach is when he talks up his macro book stating gold is the better alternative to Treasuries and equities. Negative yields or not, US bonds remain the ultimate diversifier in this deflationary environment (bond managers don't like negative sovereign yields but they better get used to them).

Tread carefully in these markets and be ready for anything. I still like high beta biotechs (XBI and IBB) and have been adding to my positions on big dips but I'm ready to stomach insane volatility in order to make the big returns.

Right now, all markets are levitating up as central banks pump massive liquidity in the global financial system. Volatility (VXX) is getting crushed and there is a lot of complacency out there.

Clearly stocks are breaking out and many bears are throwing in the towel but as stocks make new record highs, the downside risk if something goes awfully wrong goes up considerably.

The problem is that these trends can last a lot longer than you think. In fact, whenever I'm worried about the end of a trend, I remind myself of Keynes's famous quote: "The market can stay irrational longer than you can stay solvent." This remains my favorite investment quote ever.

Below, once again, Cornerstone Macro's Carter Worth says that equity performance has actually been rather disappointing. He thinks you shouldn't believe the S&P rally hype and makes a persuasive risk-adjusted case against stocks.

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